Recently proposed financial industry legislation attempts to graft prompt corrective action thresholds onto financial institutions outside the traditional application to commercial banks.
Prompt corrective action, however, means closing institutions before they are economically insolvent. Closing commercial banks in this way is rational because the moral hazard caused by deposit insurance protection makes bank creditors (primarily depositors) reluctant to act on their own to preserve the value of their investments, using their 2/3 majority powers to liquidate the banks according to standard corporate strictures.
But investors in nonbank intermediaries face no such moral hazard conflicts. Moreover, prompt corrective action taken by a resolution authority will overlap with bankruptcy law when the resolution authority acts before or instead of investors. Will creditor rights come before the resolution authority, or vice versa? Proposed legislation is silent on the point. Bankruptcy attorneys are flabbergasted.
Even if the proposition of applying prompt corrective action to nonbanks was justified, there are three main operational problems with applying the prompt corrective action approach to nonbanks. First, market capital ratios – which may be thought of as a benchmark for adequate capitalization –differ significantly across different types of financial intermediaries. Second, the minimum critically-undercapitalized level necessary to cover resolution costs would also be expected to differ across institutions. Hence, third, such an approach will require a new “Basel” negotiation process for each and every type of financial institution covered by the prompt corrective action authority.
We know two things about capital levels outside commercial banks: (1) those levels are generally higher than commercial bank capital levels and (2) those levels are necessary to cover additional risks outside commercial banks.
My academic work with Charles Calomiris (Comparing bank holding companies’ risk-based capital to other financial intermediaries, 1998, unpublished manuscript) showed that pre-Gramm-Leach-Bliley capital ratios for bank holding companies were just over 9%, life insurance companies were about 13%, finance companies were about 25%, property and casualty insurers were about 28%, and investment banks were about 29%.
Those higher capital ratios in nonbank intermediaries are held in recognition of higher risk. Finance companies and investment banks showed the highest standard deviation of asset values and banks and life insurance companies showed the lowest.
High risk intermediaries, however, require more capital to shut down in a systemic resolution regime. So while recent proposed legislation applies a critically undercapitalized capital ratio of 2% for all, logic suggests that resolving intermediaries at a high enough capital level to preserve going concern value and cover resolution costs would require higher critically-undercapitalized capital ratio thresholds for finance companies and investment banks.
Of course, setting that threshold too high, and the authorities are taking control of intermediaries that are not obviously at risk, seizing investor value and operating the firms indefinitely in the Administration’s “receivership” (the new word for conservatorship) status for what may appear to be little or no reason.
So, assuming such choices are politically palatable, how do we decide the baseline adequately-capitalized and critically-undercapitalized cutoffs for each type of intermediary? Recent proposals suggests letting FIRA decide. So, just as commercial banks and regulators have seconded personnel to Basel for twenty years now to negotiate capital rules, we will now second investment bank, finance company, and life and property & casualty insurance personnel to FIRA to debate capital requirement thresholds for every type of intermediary.
At the end of the day, however, the Basel Committee has been investigating proper regulatory capital ratios for banks for about twenty years now. Those Basel regulations still did not prevent the present banking crisis, so it is hard to see how expanding that regulatory paradigm under FIRA can be expected to have beneficial effects for other intermediaries.
† Hermann Moyse, Jr./Louisiana Bankers Association Professor of Finance, Louisiana State University, Senior Fellow at the Wharton School, and Partner, Empiris LLC. Contact information: firstname.lastname@example.org; (202) 683-8909 office. Copyright Joseph R. Mason, 2009. All rights reserved. Past commentaries and testimony are blogged on http://www.rgemonitor.com/financemarkets-monitor/bio/626/joseph_mason.